A blog of the NYU Colloquium on Market Institutions and the Leipzig Colloquium on the Market Order

Econ. 101

The AP reports today that sales of existing homes plunged 27 percent, despite the lowest mortgage interest rates in history. How could this happen?

Part of the Obama stimulus package was a tax credit for homeowners who purchased homes within a stated time frame. The credit has now expired. Economic theory predicted the program would be a failure on its own terms and it was.

Housing is a durable good and the stimulus in effect was a one-time income transfer program. What does economics tell us that individuals do with transitory additions to income? They save most of it. Because of the way this particular program was structured, the saved in the form of a durable good, that is, housing.

No permanent demand for housing was created by the program. The accelerated purchase of homes had to come at the expense of future sales. Instead of stimulating the demand for housing in the future, the program depressed it. Thus it was a failure on its own stated terms.

What of the other part of the story: declining home sales despite low mortgage rates? The demand for housing finance is a derived demand. If the demand for housing is depressed, so too will be the demand for housing finance. Hence, mortgage interest rates will fall.

The AP writer was apparently perplexed by this because he has made an elementary mistake. He confused demand and the quantity demanded. The reporter can be forgiven confusion on this point, but not so Obama’s economic advisers.

It is not just this program that cannibalizes future sales. This has been going on for a while and am not pointing at cash for clunkers but also some of the stimulus by the former President Bush, like mailing tax refunds and the like. It seems administrations are trying to cure symptoms without ever taking care of the problem. Sort of like going to the doctor who may prescribe tylenol for the headache caused by a brain tumor. Soon, the patient finds out that major surgery is need, but that is also too late.

Lately I have been thinking that perhaps low interest rates have an unintended effect on the housing market. If people are not buying because the demand curve has shifted, housing demand will not rise for a while.

Suppose a potential seller has a home that was worth $500,000 and now is worth $300,000. Should he wait to sell? What is the opportunity cost of keeping the $300,000 tied up in the house? Interest rates are very low. So if he believes that in three years, say, the price of the house will have risen by 15%, he would be getting a rate of return higher than he could expect to get elsewhere. So don’t sell — yet.

Housing sales will be lower, and thus starts will be lower, because — paradoxically — interest rates are low.

Real-estate agents will tell you that the most difficult problem they face is sellers who won’t reprice their houses. Homeowners believe housing will come back. And it will,… in about a decade (based on the housing bust in So. Calif. in the 1990s).

This interesting point may help me express my ideas on an issue I raised a couple of years ago more clearly.

Is this belief due to (1) market fundamentals (i.e., it is a rational expectation), (2) to some sort of irrationality, or (3) to “rational” expectations regarding the effects of present and future policy interventions?

I think this point is key in the ratex stuff which I sometimes discuss here and on Coordination Problem.

In case (1), generalizing very much, we have a real business cycle approach, ABCT is not ok because there are no problems of misperception.

In case (2), we have an animal spirits approach, ABCT is not ok because markets fail without the caring aid of the government.

In case (3), we have that agents are not mad, but policies have sufficient real effects to affect expectations and hamper market coordination. This is the argumentative path I prefer to rescue ABCT from ratex arguments.

I think the concept of “market failure” is a non sequitur. A market is just two parties exchanging a good/service for money (or another good/service in the case of barter).
How can it be said to “fail”?

Stepp: by this token, two people engaged in a tragedy of the commons would be as successful as two people engaging in mutually beneficial trade. That was probably Rothbard’s position, but does it make sense?

Is it really the same thing to try the best (ex ante) and achieve the best (ex post)? Is it any outcome of exchanges optimal by its very nature? Are two people apparently damaging each other without succeeding in avoiding the problem really “successful” on some higher level of welfare analysis? Is there, alternatively, anything in the exchange process that assures consistency between ex ante intentions and ex post outcomes? I’m not that optimistic.

I have no idea what you mean by “two people engaged in a tragedy of the commons.”
Ex ante intentions and ex post outcomes need not be the same, as anyone who took a flyer on a dot.bomb stock and lost money could tell you.

Where do expectations come from, if not experience? And one would expect agents to weight recent experience, their own experience, more heavily than, say, their grandparents’ experience of the Great Depression.

Due to Greenspan’s easy money policy after the dotcom bust, there was no housing correction. My Cato colleague, Mark Calabria, tells me it was the only post-war recession w/o a housing correction.

What reasonable inference did many draw from this? Stockmarkets can fall, but home prices will not. Some call that the Great Moderation. I call it the great stupification.

That erroneous expectation led people to pile into housing and fueled the housing mania. The rest is history.

Dr. O’Driscoll, I totally endorse your original post. But you and Mario seem to be saying that the reason we have such low sales, is that sellers aren’t willing to let go of their houses.

But isn’t the problem just the opposite? Isn’t there a huge glut of inventory on the market? If you were trying to explain a low quantity of sales *and rising house prices* then Mario’s theory about homeowners preferring to sit on a house would make sense.

But I thought the current state of the market was that sellers are offering huge discounts and still can’t find buyers, and potential investors aren’t pulling the trigger because they don’t think the market has hit bottom yet.

I’m with Murphy. Wouldn’t refusing to sell cause a decrease in supply and thus drive up prices? If prices are going down, doesn’t that indicate a too-large supply? I don’t doubt that people are refusing to sell because the rate of return on a house is going to be higher than the return on interest rates, but I don’t think that explains this situation.

There are huge repricing issues being complicated by government prorgams to inhibit needed downward price adjustment. Mario addressed an expectational aspect and I responded.

There is a large supply of housing in many markets, and more than is visible. Banks have a backlog of foreclosures and those homes aren’t in any measured inventory for sale.

Within this story are homeowners who want to sell, but at unrealistic prices. They have a price “memory” and expect prices to return to their recent highs “soon.” I have watched houses come on the market and be pulled back because sellers won’t accept the new pricing level.

This not so different as an unemployed worker refusing job offers because he doens’t accept that his equilibrium wage has fallen. It’s a micro, individual story within a broader market analysis.

Let’s suppose for the sake of argument that there is no “ex-post vs ex-ante” problem of the sort that Pietro mentions. Does it then follow that there can be no “market failure”? From a utilitarian point of view it certainly doesn’t. There could be another course where there is no market transaction where both parties come away with higher welfare. Market failure isn’t a non-sequiteur, it’s a theory of human behaviour. The theory being that in situation XYZ it is better if the state determine action than individuals. We may broadly disagree with this theory, but it’s not a logical fallacy or contradiction.

I believe in natural rights, and don’t have a problem with natural rights thinking. I think Rothbard’s “Ethics of Liberty” is quite good. (I skimmed the criticism by Ed ? you linked to, noting that he’s a God-ist–and where’s the evidence for that?–, and will come back to it some time.) I’m also opposed to utilitarianism. I don’t think either you or Pietro have made the case for “market failure.”

Why buy a house at market price wehn you can buy foreclosed properties at a much lower price? If I had enough money to be buying houses, that’s what I’d be doing: buying really, really cheap foreclosed houses and then selling them at a higher, but still below market, price. I’m sure those kinds of things are happening, and they are no doubt keeping prices low. And this sort of activity is also, I bet, masking exactly how bad housing sales actually are.

I didn’t mention, and I wasn’t thinking at, the idea of market-improving government intervention. I just stated the fact that not all social outcomes become *magically* optimal, efficient and unimprovable only because individuals freely engage in exchanges. That’s Rothbard’s welfare economics, probably, and it doesn’t make much sense to me.

To me, there’s no chance of convincing anyone that two fishers fishing in the same lake and damaging each other through overfishing because of lack of definite property rights (i.e., stuck in a tragedy of the commons) are in reality engaged in efficient and optimal strategies.

The idea that voluntariness logically implies optimality is not applicable beyond the individual and ex-ante level (by the way, Prof. Rizzo gave an interesting lecture at FEE on the subject, I hope I’m not getting it wrong). Single individuals do act as if their plans are ex-ante optimal, but no presumption of optimality can be assumed when there are interactions among several subjects, and outcomes (ex post) are analyzed in place of intentions (ex ante).

That said, I’m not interested in natural rights, the whole argument is an abuse of reason, and thus a nonstarter for political thought: nothing in logic enables us to derive judgments of value out of nothing.

PS Mises is a much better starting point than Rothbard also on this point. In “Human action” he distinguishes legal and praxeological property rights, and defines the former as “actual” rights and the former as externality-free ideal rights which enable the market process to run more or less smoothly.

A lot is being said about buyers and sellers as if the current real estate market were a true free market governed by its own dynamics. However, I recently learned about a theory -conspiracy if you may- that holds that banks and hedge funds are getting in the way of making it easy for potential buyers to acquire properties. Their goal is to become “landlord, inc.” and get their money/loans back via rents. Given the path things are taking, this is not out of the question. Where I live, some units have just been rented at primo prices pre-debacle. It appears there is a lot greater demand for renting these days, so why push the selling/mortgages business?

The fact that there are so many stories about people with superior credit not being able to get pass the bank door makes the above theory credible.

I didn’t read the whole of the other stuff you linked to, including Cohen, etc.
I think there’s nothing wrong with natural rights reasoning, and a lot wrong with utilitarianism, as Rothbard pointed out.

I understand that there is a lot wrong with utilitarianism, particularly formal theories of utilitarianism that seek to make very careful comparisons.

However, I think that there is more wrong with natural rights. I’ll mention a few of the problems briefly here…

Firstly, since this is an economics blog it’s interesting to discuss the place of economics. Let’s suppose that you and I accept that natural law is the correct moral system. In that case is there any need to consider economics at all? If we agree that what is important is that each transaction fulfil certain moral rules then where does that leave economics. All we can use economics for is to gain some expectations of the long-term future. Our economic analysis may indicate that the future will be rosy, or it may indicate that it will be bleak. But, it doesn’t matter either way because according to the natural rights view we are compelled to act in a particular way regardless of the outcome. Economic and political thought becomes like stamp-collecting or predicting the astronomical fate of the universe. If we discover that human civilisation will end because of our adherence to natural rights then that’s just tough for us and humanity. (N.B., I don’t think that worldwide adherence to natural rights would necessarily result in that outcome, I’m just pointing out the structure of the argument).

Secondly, let’s suppose that we agree that if Bill owns a couch and Tim owns a rug then Bill and Tim can trade those items. In the natural law sense what we mean by “own” is that someone has the moral right to the possession, not that they strictly have the legal title. The moral ownership stems from the origins of the possession itself. If Bill has stolen the couch then he can’t morally trade it with Tim.

As I wrote in the earlier thread…. Let’s suppose that I trade something with a lord, say Viscount Ridley. Now, natural law says that what I trade and he trades must not be acquired through coercion. However, Viscount Ridley’s ancestors got their land through coercion. I may not be descended from nobility, but that doesn’t mean that my ancestors didn’t get their wealth entirely from trade. So, if all property is “polluted” in this way, and it all is, then how can any trade occur as natural law describes?

So, the natural law thought experiment has no correspondence to reality. All land has been stolen at one time or another. You may say “we should forget about who coerced who centuries ago”. In my view that’s a valid argument. But, it’s a utilitarian argument. What you’d be arguing is that everyone would be better off now to forget about the earlier “pollution” of property through coercion.

Lastly, we should ask ourselves whether others will be persuaded by natural law. I think it’s very doubtful that they ever will be. I don’t think that the common man is really concerned about whether the political order they live in reflects some higher moral order. I think what concerns them much more is whether it serves their interests. I think that the electorates of the world must be given utilitarian reasons for adopting Classical Liberal policies.

[…] Gerald O’Driscoll over at ThinkMarkets does precisely this today. Nothing that has gone on so far with the housing market would be unpredictable with a little return to the lessons of Econ 101 about incentives and information, and how markets work to coordinate plans through time via relative price adjustments and profit and loss accounting. Policies produce incentives, when individuals in the system follow the path those incentives lead them to pursue, we should not be surprised (and certainly not disappointed). The policies adopted produced the results we see, not individuals behaving badly or behaving ‘irrationally’. Unfortunately, in our efforts to be ‘sophisticated’ we often confuse simple economics with simple-minded economics. But there is nothing simple-minded about returning to simple basics of economic science. This ain’t rocket science, but individuals respond rationally to incentives and demand curves slope downward and supply curves slope upward. […]

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The problem that is presented in the housing market is a lack of demand for the homes that are on the market currently. Obviously with a decrease in demand for these homes (for multiple reasons, the main one being the concern that these homes will continue to drop in value) people are less inclined to stick it out and hold on to their properties. Many families are selling their homes for half of what they bought them for. Meanwhile others are “walking away” from their mortgage because they owe more on the home than it is worth. Trying to drive up the value of these homes again by implementing tax credits and lowering interest rates, to lower than they have been in 30 years, is not something that will help. The best solution for Obama is to be Laissez Faire about it and let the housing market pick itself back up.

In the Silicon Valley, first time home buyers with and average credit, can put down no more than 5 percent on a home worth up to $400,000! Furthermore the interest rates are lower than 4 percent. On top of that there are housing trust companies that are handing out up to fifty thousand dollars (interest free for 30 years) towards the down-payments on homes for first time home buyers. Sure all of these implements makes it a whole lot more tempting to purchase a home compared to throwing your money into rent, where it will never be seen again. And sure this will slowly create more of a demand for properties. However it is very risky having people with so little all of a sudden owning homes. My worry is that many first time home buyers are irresponsible and not ready to make the necessary payments on their homes because many of them don’t have the necessary credentials to own in the first place. Making it so easy to purchase a house (when the housing market is already very low) will inevitably lead to that many more people who are not actually ready to take on the financial responsibility of being a home owner. Once that becomes the case more homes will once again be foreclosed. And the cycle repeats itself.

Instead of incentives for non homeowners to go out and buy, there needs to be incentives for homeowners that own to hold on! When the interest rates dip and there are very low down payment requirements to buy, less and less individuals are willing to rent. Instead if more people are willing to rent then those who want to wait till the housing market increases to sell; can instead rent out their properties, and for a higher amount.